Putting all your money into the shares of just one company is extremely risky. Investing it in a fund such as a unit trust reduces your exposure to the fortunes of any one company, but the ultimate in diversification has to be a fund of funds (FoFs).

Putting all your money into the shares of just one company is extremely risky. Investing it in a fund such as a unit trust reduces your exposure to the fortunes of any one company, but the ultimate in diversification has to be a fund of funds (FoFs).

FoFs are structured like any other unit trust or investment trust, but instead of holding shares or bonds directly, they hold stakes in other pooled investments. This enables investors, for the same outlay, to spread their risk across many more shares than they would be exposed to in a traditional unit trust.

Many of the major fund management groups run at least one FoFs alongside their range of directly invested unit trusts. Some FoFs invest solely in the units of other funds run by the fund management group, while others invest broadly across any unit trust on offer. Others specialise in one particular investment sector or geographical region.

Portfolio Fund Management specialises in FoFs. The group runs eight of them including two general funds and six specialist funds including some investing in UK growth, Asia, America and Japan.

Of the two general FoFs, the Portfolio FoFs is the more cautious, investing 15 per cent of its assets in bonds and cash, while the Portfolio Performance Fund is slightly more adventurous, says Tim Miller, chief executive of Portfolio.

Claire Arber of the Association of Unit Trusts and Investment Funds says FoFs are more appropriate for people with a lot of money to invest than for first-time investors. Mr Miller agrees: "The more money you have to invest, the more you want diversification," he says. First-time investors, he says, usually want a very high-risk investment.

"They can be useful for those investors looking for a once-only investment, and who want a balanced investment profile," says independent financial adviser Philippa Gee of Gee & Company in Shrewsbury. "The disadvantage is that the charges are usually much higher," she adds. If you know you are likely to add further savings to your investment in future, you are probably better off picking a different unit trust with lower charges. Then, when you come to invest again, choose unit trust with another profile which complements the first. "So you are building up your portfolio," says Ms Gee.

FoFs are usually expensive because they often have two layers of charges. First, there are the initial and annual management charges on each fund within the fund, and on top of that comes the charges levied by the FoFs manager.

But M&G's FoFs, which invests in only those funds it manages itself, get full rebates of charges from each of the funds they invest in, says Vivian Bazalgette, chief investment officer at M&G. Its FoFs simply carry a 1.5 per cent annual management charge, no front-end charge and an exit charge which reduces to nothing after five years.

Taxation is one major advantage cited by FoFs managers. Each time the fund switches investments, there is no capital gains tax to pay, whereas if an individual investor switched holdings in their own portfolio, they would be liable to the tax on any capital gains they made with the sale.

But opponents of such in-house FoFs argue the managers have their hands tied because the range of funds at their disposal is so small. Often, to get a broad enough spread of funds, they are forced to invest in even the poorer performing funds in the management group's stable.

"It may be that one provider is good in, say, fixed income but may not be good in UK equities," says Ms Gee.

But M&G argues that there are advantages to its method. "You can co-ordinate the stock selection around the world - you know the funds have the thread of the same style running through them," says Mr Bazalgette. Also, the manager knows exactly what each fund is investing in at any time, rather than having to wait for the fund's quarterly report to be published.

The manager is also likely to have more in-depth knowledge of the individual fund managers, and be aware of when they are likely to move on.

Sales of FoFs have grown, but not at the pace experienced in some other fund sectors. According to AUTIF figures, gross sales of FoFs were up around 18 per cent in 1999 from the year before.

But Philippa Gee believes they will become less relevant for investors in future. "Particularly as investors become more aware, people will not feel they need to have everything sitting in one place, so the demand [for these funds] will diminish," she says.